As 2018 begins, we would like to provide a brief review of market and economic events in 2017 along with an in depth look at what we expect for 2018. We hope all of you had a pleasant holiday season and wish you and your family a happy and healthy New Year!
2017 in Review
The last year has defied much of the conventional wisdom that was projected at the start of 2017. For starters, many thought that political volatility would spill over into investment markets. In spite of the volatility in Washington D.C., markets performed well, with U.S. large cap stocks rising around 20% for the year. There was a wide dispersion amongst leaders and laggards; however, with growth stocks (measured by the Russell 1000 Growth index) returning 30% while value stocks (measured by the Russell 1000 Value index) returning 13%.
One concern surrounded emerging market investments, which many anticipated would be held back by renegotiated trade agreements. Instead, emerging markets were one of the best performing asset classes this year, with the MSCI Emerging Market (“EM”) equity index returning 31%. Fears of a trade war were unfounded and the pullback from the Trans Pacific Partnership (“TPP”) agreement has not seemed to have a major impact on trade, but simply eliminated the U.S. from setting the terms while simultaneously giving China a bigger seat at the table. While emerging market equities performed well last year, they have lagged the S&P 500 by around 12 percentage points, annually, over the last five years. The shift towards EM outperformance is a favorable development and one that could continue, as we will outline in our 2018 Outlook section.
Bonds, which many anticipated to be under pressure due to rising yields, as a result of economic stimulus, managed to generate positive returns. The Barclays U.S. Aggregate Index returned around 3%, in 2017. Yields rose, but only on the short-end of the curve, with the 2 Year Treasury yield hitting 1.79% in December, up from 1.20% at the start of the year.
2 Year Treasury Yield - 2017
The reason for the strong move higher in short-term yields was due to the Fed raising rates three times, ending the year at a range of 1.25% to 1.50%. While short-term yields rose, long-term yields held fairly steady. The Ten Year Treasury was at 2.40% at the end of December, down slightly from its 2.45% level at the end of 2016. Thirty Year Treasuries yielded 2.74% to close the year, down 32 basis points (“bps”) from their level of 3.06% at the end of 2016.
On the economy, the U.S. performed fairly well, with gross domestic product (GDP) growth averaging 2.49% compared to 1.82% in 2016 (St. Louis Federal Reserve, Dec 2017). U.S. consumer sentiment hit an all-time high in the fourth quarter, driven by continued improvement in the jobs market along with appreciating house prices. Lest politicians try to claim credit for the acceleration in economic growth, global growth has also ticked higher over the last year, a phenomenon that has little to do with the U.S. president. German business optimism hit a record level in November. Japan’s economy has grown for seven consecutive quarters, the longest streak in nearly two decades (New York Times, Nov 2017). After decelerating a bit to 4.3% economic growth in 2016, emerging market growth picked up to 4.6% in 2017. By comparison, developed market growth was around 2.1% over the last year (International Monetary Fund, Sep 2017).
As we take stock of where markets currently sit, the major surprise over the last year was the relative lack of volatility. We noted in our most recent edition of Viewpoints that the market undergoes, on average, a 14% correction in any given calendar year. In 2017, the correction was merely 3%. Though we prefer to make money from rising equity prices rather than see the market decline, a ‘pause that refreshes’ is always welcome as it keeps markets from becoming too euphoric. The exact timing of a correction is anyone’s guess, but some of our positioning within portfolios, which we will detail further in our 2018 outlook, reflects taking some profits in areas that have done remarkably well (the U.S.) and turning towards more attractive valuation opportunities abroad (such as in emerging markets).
In closing out our thoughts on 2017, we leave you with a quote from Sir John Templeton: “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” Though stocks have performed well in 2017, we do not see widespread euphoria in the equity market. The only area we perceive to be awash in speculative abundance is Bitcoin.
Gains of 1,800% over one year are fun for those who are invested, until the music stops. Rarely have prior bubbles reached such an extreme level of speculation in such a short period of time. Perhaps the technology that underpins the blockchain will be transformational, but to make bets on cryptocurrencies continuing their ascent is simply rote speculation and not something we desire to engage in with our portfolios.
We will now turn our attention to the year ahead, with a focus on key themes across various asset classes and global markets.
The U.S. Economy
Suffice it to say, we are not in the early innings of the U.S. economic expansion. The last recession in the U.S. was over 8 years ago. From a historical perspective, the average expansion has lasted around 4 years. The bottom left chart shows that this has been the third longest economic expansion in the last hundred years. To be certain, periods of economic growth have lasted longer in recent decades. The primary reason for this is the fact that the U.S. is less of an industrial economy, with bigger booms and busts, and more of a service economy, based on technology development and healthcare, with less of a capex cycle.
Another reason why the current expansion has lasted so long is illustrated in the chart to the right, which shows the degree of economic growth in historical expansions. The current expansion, illustrated by the bottom, light blue line, shows that we have been growing at an incredibly slow pace during the current cycle. Consumers have not taken on excess leverage like they have in prior cycles. While businesses have taken on a significant amount of debt, it has been primarily used to buy back shares rather than pursue projects or mergers and acquisitions.
As we look out to 2018, we do not see a risk of a recession in the next twelve months but are closely watching consumer and corporate behavior. Economic cycles do not die of old age alone, but rather as a result of excess leverage going into the system, only to see the Fed pull the punch bowl away right at the time when consumers and companies are leaning on it the most. Though the Fed has raised rates recently, interest costs are still low and credit is easily accessible. This implies that consumers still have room to take on excess leverage. While this is beneficial to spending and ultimately economic growth in the near term, it could create problems a few years down the road.
Central Bank Policy
The key question regarding the Federal Reserve’s outlook for raising rates is not whether or not they are going to continue raising rates (they will) but rather the pace with which they will raise rates. At present, the Fed projects interest rates will end 2018 at 2.13% and by the end of 2019, they will be at 2.69%.
By comparison, the consensus amongst Wall Street strategists is that they will end 2018 at 1.83% and end 2019 at 1.99%. In short, the Fed is looking push rates 30 bps higher than the market expects at the end of 2018 and 70 bps higher than the market consensus in 2019. If the Fed moves faster than the market expects (or desires) it could create additional volatility. In our view, the combination of some slowdown in the economy, combined with the Fed sticking to its current rate hike projection remains the main risk for equity markets in the next year. Granted, if the pace of economic growth does moderate and inflation remains tame, it may prompt the Fed to pause on rate hikes given lack of price pressure. Incoming Federal Reserve chair Jay Powell has indicated that he intends take similar approach to Janet Yellen, with a data dependent perspective in setting the agenda for future Fed policy. In our view, the Fed will continue to maintain an easy policy of hiking rates but will hold back the reins if the market experiences a correction.
From our perspective, the bigger question for markets over the next few years is how the continued withdrawal of liquidity from the system will affect markets. Since the financial crisis, central banks have moved into uncharted territory with pushing rates to negative levels and engaging in quantitative easing. As a result, their balance sheets have grown as they have pushed liquidity into the system.
The preceding chart shows balance sheet changes at the four big central banks. Most pronounced is the Fed’s active reduction of their balance sheet, which is occurring presently. The European Central Bank (“ECB”) is continuing to expand their balance sheet, as is the Bank of Japan (BoJ). The fact that these two regions are still providing liquidity support to their markets is one reason why we are continuing to look abroad for outperformance. However, as we get closer to 2019, we can see that the major central banks will move from balance sheet expansion, in aggregate, to contraction. This will have a flow through effect on asset markets that should be watched closely and could create volatility as the punch bowl gets taken away from the table in the next year.
Though this is an area we’d rather not touch, even with a ten-foot pole, we’d be remiss to not comment on it briefly given how much it comes up in client conversations. 2017 will go down as one of the strangest dichotomies between the news cycle and the market’s lack of concern, that we have seen in our careers. For starters, the ease of accessibility to news brings about the constant need for a new headline, of which there was no shortage of with what often resembled a reality TV show occurring in Washington D.C. Yet with each moment of political turmoil, the market proved resilient. To cite one example, North Korea’s nuclear sabre rattling, matched by President Trump’s promise of “fire and fury” caused a bit of overnight panic in the equity futures market back in August, but prolonged fallout in the markets or the geo-political scene did not materialize.
The lack of pressure on market levels is puzzling, but in truth, the market tends to ignore political volatility over the long-term. To draw this example out further, the following chart shows long-term equity returns from the S&P 500, with a variety of political events overlayed. In spite of wars, recessions, impeachments, assorted financial crises, and a myriad of other political events, the market has continued to climb the wall of worry.
That is not to say that drawdowns and corrections as a result of political volatility are non-existent. To be sure, they do occur and may affect the investing landscape in 2018.
On tax reform, the Tax Policy Center estimates that taxes will be reduced by $1,600 on average, with a decline occurring across all income groups. Taxpayers in the middle-income quintile (income between $49,000 and $86,000) would receive an average cut of around $900.
Those in the upper end of the income spectrum would see taxes reduced by $1800 to $7600. The interesting wrinkle is that voters are pessimistic about the plan. Just 25% approve of the plan because they think it will disproportionately benefit the rich. In spite of negative sentiment regarding the tax bill, the combination of consumer sentiment hitting multi year highs, plus a reduction in taxes, should help give a modest boost to economic growth. Jobs are fairly easy to come by, the housing market is strong, the stock market is performing well, and taxes are being cut. Though most don’t view the tax cut as directly benefiting them, it is pushing in the right direction rather than creating another headwind.
Global Equity Markets
Coming off the heels of a strong calendar year, we expect positive returns for global equity markets with performance variation between U.S. and international markets. In the U.S., 2017 operating earnings for the S&P 500 are estimated to have grown by 17.66%, year over year. We highlight this growth to show that asset price appreciation has not been solely as a result of euphoric sentiment but have been backed by actual corporate earnings growth.
Growth has come from multiple sectors, with technology, health care, and energy all contributing significantly. However, estimates for 2018 appear too aggressive in our view. Analysts estimates are for full year growth of 15.6% for the S&P 500 next year. By comparison, the historical average growth rate for earnings is 5.51%. Coming off a relatively low base in 2015 and 2016, it was not difficult for earnings growth to hurdle the historical average. Corporations will be challenged to continue growing at a rapid rate, especially if there is downward pressure on margins from rising wage and interest costs. Consider how high U.S. profit margins (at all-time highs) are compared to global margins (still below prior cycle highs).
Though we should note that U.S. profit margins are unlikely to revert significantly lower, given the makeup of the index being tilted more towards technology and its higher embedded margins, there is simply less room for margin expansion and thus less fuel for future earnings growth. This is ever more the case now that we are two years past the mini earnings recession experienced at the end of 2015 and early 2016.
What is interesting to note is how much lower margins are in ex-US equity markets, with emerging markets in particular experienced substantial contraction. At present, emerging markets have forward profit margins of 7.3% compared to 10% margins, ten years ago.
Profit margins in Asia have significant room for expansion, particularly as tech and other service companies become a greater part of the equity index composition there. This is one of the reasons we continue to favor adding to equity investments in emerging markets on the heels of stellar performance this past calendar year.
In addition to margin expansion, there are other pillars supporting outperformance from emerging market equities going forward: currency appreciation, valuation expansion, and earnings growth. Currency valuations across emerging markets are trading more than one standard deviation below their historical average, vs. the U.S. dollar, a 29% discount.
Emerging market earnings are expected to grow around 15.6% next year. Though this is a similar growth rate to S&P 500 estimates, it is more believable considering higher growth across EM economies combined with the aforementioned potential for margin growth. Emerging markets also trade at a 12.6x forward price to earnings ratio vs. 19.82x ratio for the S&P 500.
These elements all add up to the conclusion that investors should continue to rotate from U.S. equity exposure towards international and emerging market equity exposure. The U.S. may continue to perform well, as momentum has a funny way of continuing until it doesn’t, but it is our view that the runway for equity market returns is much longer abroad than it is here given the potential for both valuation and earnings rerating higher.
Global Bond Markets
Heading into 2018, most developed market bond yields on the long end of the curve are little changed from a year ago. Generally speaking, international developed bonds offer little value, with German 10-year bunds yielding 0.40% and Japanese 10-year bonds yielding 0.05%. While no one would claim that U.S. 10-year bonds are a great value at 2.40%, they are a relative high yielder in the realm of developed markets.
Emerging market bonds have performed well in the last year but still generally offer a yield spread premium to developed markets. Brazil 10-year bonds yield around 10% while Mexico’s 10-year debt yields around 7%.
In essence, we do not see much incentive to buy longer duration bonds within developed markets but rather we believe there is reason to stick to the very short end of the curve, where yields have risen substantially over the last year, as noted in the 2017 recap. For instance, Two Year Treasury bonds are yielding 1.85% with a duration of 1.9 years. By comparison, 5 Year Treasury bonds are yielding 2.2% with a duration of 4.6 years.
Investors are getting significantly better yield per unit of duration in bonds maturing in 0-3 years than they are in bonds maturing 5 years, or further, out. From our perspective, investors are best to avoid the interest rate risk at the long end of the curve and take advantage of more attractive yields in the short end of the curve within developed markets.
In emerging market bonds, yield spreads have contracted but still offer some premium to developed market debt. At present, EM government bonds have a spread of around 287 bps to U.S. Treasuries while EM corporate bonds have a spread of 225 bps to Treasuries. Assuming spreads do not contract, the yield to worst across U.S. dollar denominated debt in emerging markets is around 5.29%, with a duration of around 6.8 years. This is not the bargain it was two years ago when yields were closer to 6.25% but you are picking up around 0.77% yield per unit of duration compared to 0.45% for the Barclays Aggregate index. Given the strength of recent returns, we’d would caution against expecting more than coupon pickup within the space but think emerging market bonds warrant an allocation for investors in the next year.
Looking forward into 2018, we do not see cause for concern with respect to an economic slowdown but rather would caution investors to not grow complacent coming off of a year where returns were so strong across a wide variety of asset classes. Market volatility is usually the rule, not the exception and while 2017 provided an enjoyable respite from drawdowns across stock markets, we could see pockets of volatility occurring in the next year.
One such cause for volatility could be the continued removal of easy monetary policy from central banks across the globe. Investors have enjoyed the Fed and other central banks keeping rates low for some time and while liquidity is not going to be immediately snatched from the system, we are in the early stages of a tightening monetary policy. While corporations have been more apt to use leverage than consumers have in this cycle, we would caution that we are closer to the end of the U.S. economic cycle than the beginning and some period of greater volatility in markets is something to keep a look out for.
In light of that, we believe a continued, measured shift away from U.S. equities to international equities, emerging markets in particular, is warranted. Emerging market equities have a longer runway for positive performance given compressed valuations and margins, combined with higher economic growth potential.
Investment advisory services offered through Independent Financial Partners, a Registered Investment Adviser
WhartonHill Investment Advisory is not owned or controlled by Independent Financial Partners
The opinions voiced in this material are for general information only and are not intended to provide specific investment advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
All data is from Bloomberg, Wall Street Journal, and Morningstar as of December, 2017 unless otherwise noted